What the IRS starts with
IRS guidance says the key is determining what the shareholder-employee did for the S corporation and looking to the source of the corporation's gross receipts. Revenue generated by the shareholder's services points toward wages. Revenue produced by other employees, capital, or equipment may support a different allocation, although management and administrative work still counts.
The IRS also lists training and experience, duties and responsibilities, time and effort, dividend history, pay to non-shareholder employees, bonuses, comparable pay, compensation agreements, and any formula used. No single factor or salary-to-distribution ratio decides the answer.
The three-document file every owner should keep
Document one: a written job description that lists the owner's actual roles, tasks, responsibilities, required experience, and approximate time allocation. This makes the services being valued clear.
Document two: a credible time record. The IRS guidance focuses on time and effort devoted to the business, so calendars, project records, or periodic time summaries can support the hours used in the analysis.
Document three: a wage benchmark memorandum that identifies the occupation, geography, data release, and adjustments used. BLS data is useful market evidence, but a percentile should be selected from the owner's facts rather than assumed from revenue or business size alone.
The 60/40 myth
What happened: In David E. Watson, P.C. v. United States, an experienced CPA paid himself $24,000 a year while taking much larger distributions. The court accepted $91,044 as the annual value of his services and found a $67,044 wage understatement for each of the two years at issue. The $67,044 was wages, not tax owed.
Why it happened: The $24,000 salary did not match his experience, work, and the value of the services producing the firm's income. The Eighth Circuit affirmed the result. It did not create a 60/40 rule or a universal minimum salary for other owners.
How a memo helps: A defensible compensation memo documents the reason for the salary before a challenge. It connects duties, time, experience, the source of business receipts, location, and credible market wage evidence to the number in plain language. The risk is not choosing a low salary. It is choosing one you cannot explain.
When to revisit the number
Reasonable compensation is not a set-it-and-forget-it decision. Revisit it when the owner's duties, hours, experience, staffing, service mix, location, or comparable wage data materially changes. Keep prior analyses with the payroll and distribution records so the company can explain changes from year to year.
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